Tuesday, January 11, 2011

Hyper-inflation erupts when politicos control the money supply; bankers focus on their own interests, and hyper-inflation doesn't serve them.

Without a systemic understanding, history and the present both devolve to Toynbee's "one damned thing after another." If we are to make sense of history--and with the aid of history, to make sense of the present--we need what I call an integrated understanding.

Schools of thought develop around key insights, and then they attempt to project these core insights onto the entire world. This over-extends the original context of the insights, and so the school becomes discredited.

I am a pragmatist rather than an ideologist, and so I have no patience for ideological purity. As a result, I don't claim any "school of thought" or economic camp as my own; I try to incorporate the core insights from all schools of thought into my own understanding.

We can look to the Keynesian and Marxist schools for examples. Marx systemized some core insights into the dynamics of Capitalism, the key ones being 1) eliminating competition via monopoly or cartel was the road to spectacularly reliable profits, hence the power of monopoly capital, and 2) there is a critical difference between industrial and financial capital.

To lift Marxism to a quasi-religious system discredits the whole. But to reject Marx's work in its entirety is to miss the fundamental drivers which still operate (look no farther than banks, Sickcare and the military-industrial complex for examples of cartels which control vast industries, income streams and capital).

Keynes' key insight was the role central banks and governments could assume to ameliorate specific kinds of financial depressions via borrowing and fiscal stimulus. But politicians found that keeping the spigot open all the time increased their power and longevity in office, and so what was to be used sparingly and infrequently became the default policy.

We are now witnessing the exhaustion of permanent Keynesian stimulus. We shall soon see its repudiation as a systemic "solution."

Which brings us to everyone's favorite campfire debate, inflation vs. deflation.What this really boils down to is whether the financial world will expire from fire (hyper-inflation) or ice (deflationary death spiral).

My own position is that hyper-inflation is first and foremost a political phenomenon--it is necessarily the result of specific political policies and choices.

In my view, there are two keys to understanding deflation and hyper-inflation: one is cui bono, to whose benefit? Who benefits from a hyper-inflation that wipes out all cash and cash-equivalent financial assets?

If we take it as axiomatic that hyper-inflation is a political process, then we have to conclude that hyper-inflation serves some powerful interests who would support the policies that would bring it to fruition.

My problem with the "hyper-inflation is inevitable" school of thought is that I cannot identify what powerful interests would gain from the destruction of the currency and all financial wealth. A hyper-inflationary wipeout certainly wouldn't benefit the Financial Power Elites who hold the vast majority of the financial wealth. Yet it is this very Elite which wields the preponderance of political power.

Thus you end up with this untenable conclusion: the politically powerful Financial Elite will consciously choose to self-destruct. I don't buy that as a likely scenario. If inflation started destroying their wealth, then they would instantly influence political policy to reverse course to preserve their wealth.

I suspect this may explain Great Britain's abrupt and profound policy reversal from extreme Keynesian stimulus via sovereign borrowing to severe austerity.

The second key understanding is that debt is an expense to the borrower (and thus to the government) and an asset to the bank/lender/owner of the debt.Those who see hyper-inflation as inevitable tend to focus on the benefits of wiping out debt, but they forget that wiping out all debt via hyper-inflation also wipes out the assets and wealth of all who hold that debt.

This leads to a simple yet profound question: who is more politically powerful-- those who owe the debt or those who own it? And that brings us to a very interesting essay from the Austrian School of economics.

I am a student of history and economic thought, not a scholar, and so I read this paper forwarded to me by frequent contributor U. Doran with keen interest: Deflation vs. Inflation (An Austrian Analysis).

Boiled down to its essence, this insightful analysis concludes that hyper-inflation only arises when politicos (politicians) control the money supply. We can best grasp this by returning to cui bono--to whose benefit?

Central banks exist to protect and enrich the banks. Understanding that will go a long way to explaining why hyper-inflation simply isn't in the cards unless the central bank (or banking cartel) loses control of the money supply to the politicos, who never met a deficit spending budget they didn't love with all their heart and all their mind.

That too is understandable in terms of cui bono: politicians succeed in holding onto power by passing out largesse to their constituency. In democracies, that includes contributors and voters. In dictatorships, that is often the Army and a small Elite of landowners.

The authors of this paper contend that the infamous hyper-inflation of the Weimar Republic in Germany only arose because the political class was in control of the money supply. The central bank was a tool rather than a potent force of its own.

Why would bankers allow hyper-inflation to destroy their assets? If they had any say at all in the matter, you can bet that their strong preference would be for just the sort of policy the Federal Reserve is pursuing: a modest inflation that enables their debtors to make their payments.

The chief debtor now is the Federal government. The banking cartel won't benefit from sovereign default, at least they won't if they own any sovereign bonds.

Politicians, on the other hand, are chafing under the constraints of debt and interest payments. High inflation is acceptable if that is the only pathway to keeping the money spigots wide open and the largesse flowing to constituents. For politicians, there is no future beyond four years. Bankers have a longer view; they must preserve their assets, and hyper-inflation destroys financial assets.

Some claim the super-wealthy will simply move their wealth into gold or hard assets and wait out the hyper-inflation. We should note that all the gold ever mined is worth at best $7 trillion, and global assets are roughly 20 times this sum.

There is simply no credible reason politically powerful holders of debt assets (bonds, mortgages, etc.) would allow their wealth to be destroyed: what possible benefit would that offer them? It makes no sense.

This paper makes a well-reasoned case for keeping the money supply out of the hands of politicos. Central banks and the banking cartel can be trusted to look out for their own interests, and even if we find their political power and self-serving policies despicable, they are at least reliable and overt.

We should also note that mild deflation benefits the owners of debt assets. If prices are deflating by 2% a year, even those holding bonds which yield a meager 1% are effectively earning 3% on their wealth.

Mild deflation makes debts more onerous to the borrowers, but if these borrowers are politically impotent, then they will simply have to "buck up" or default. As long as the majority of debtors continue to service their debts, the owners of the debt prosper.

Lastly, consider the profound difference between printing money and borrowing money. Governments which create hyper-inflation actually print the cash; governments which borrow it via selling bonds have "governors" on the amount of debt they can sell and service.

Deflation vs Inflation is a bit dense in sections, but it is very readable and closely reasoned. I recommend it to anyone seeking an Austrian School understanding of the monetary and political roots of deflation/inflation.

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